Does Renting My Home for Two Months Kill the $500,000 Exclusion?

Here’s how renting out your home while you take a two-month vacation interacts with your ability to use the $500,000 home-sale exclusion ($250,000 if single).

Remember, you have to use the home as a home for two of the five years before sale to qualify for the home-sale exclusion.

Exclusion Rule

The tax code allows you to exclude from gross income up to $500,000 of gain (joint return, $250,000 if single) from the sale or exchange of your home if

  • during the five-year period ending on the date of the sale or exchange
  • such property has been owned by you or your spouse for periods aggregating two years or more and
  • used by both you and your spouse as your principal residence for periods aggregating two years or more.

Planning note. The ownership and use periods do not have to be the same.

Vacation Rule

Here’s what the IRS said in an example that fits the vacation activity:

Taxpayer E purchases a house on February 1, 1998, that he uses as his principal residence. During 1998 and 1999, E leaves his residence for a two-month summer vacation.

E sells the house on March 1, 2000.

Although, in the five-year period preceding the date of sale, the total time E used his residence is less than two years (21 months), the section 121 exclusion will apply to the gain from the sale of the residence because, under paragraph (c)(2) of this section, the two-month vacations are short temporary absences and are counted as periods of use in determining whether E used the residence for the requisite period.

To summarize, E was living in the house for 21 months and on vacation for four months, giving him a total of 25 months. To take advantage of the $500,000 home-sale exclusion, E had to use the home for 24 months or more. The IRS says he meets the 24-month rule because his vacation time counts as use of the home as a home.

Rental

Your home is going to be a home under the vacation-home rules when you use it as your home for a number of days that exceeds the greater of

  • 14 days, or
  • 10 percent of the number of days during such year for which such unit is rented at a fair rental.

Example. You rent the home for 60 days and live in it for 305 days. Your home is a home under the vacation-home rules because your personal use is greater than 14 days and greater than six days (60 x 10 percent).

At the end of the year, you need to tally the rents you received and allocate the home expenses to the rental based on the ratio of rental days to personal days.

If you have a tax loss on the rental part, it’s not deductible against other income, but all is not lost. The law allows you to carry over any losses to the next tax year, when they again become available against your home-rental activity.

Know These Tax Rules If Your Average Rental Is Seven Days or Less

If you own a condominium, cottage, cabin, lake or beach home, ski lodge, or similar property that you rent for an “average” rental period of seven days or less for the year, you have a property with unique tax attributes.

Seven days example. Say you have a beach home and you rent it 15 times during the year, for a total of 85 days. Your average rental is 5.7 days. That’s an average of seven days or less for the year.

The right type of beach home or vacation cottage can produce great tax results when the average rental period is seven days or less. But it’s tricky because when the average rental period is seven days or less, the property is not a rental property as defined by the tax code. Instead, the property is a commercial hotel type property that you report on Schedule C of your tax return if you provide services in connection with the rentals, or

a weird in-limbo property that you report on Schedule E when you don’t provide services.

If the property shows a loss, you can deduct that loss on either Schedule C or Schedule E if you can prove that you materially participate. With the seven-days-or-less-average rental, you likely have only two ways to materially participate:

  1. The combined participation by you and your spouse constitutes substantially all the participation in the seven-days-or-less-average rental activity when you consider all the individuals who participated (including contractors).
  2. The combined hours of participation by you and your spouse in the seven-days-or-less-average rental activity are (a) more than 100 hours and (b) more hours than the participation of any other individual.

Example. Your seven-days-or-less beach rental produces a $20,000 tax loss for the year. On this rental, you spend 65 hours during the year. No other person works on the rental. You materially participate in this rental, and the $20,000 is deductible—period (regardless of its location on Schedule C or E).

If you have a profit on the rental, you likely have a Section 199A deduction when you report the rental on Schedule C as a business. Although not deemed a business by Schedule E reporting, the Schedule E rental could rise to the level of a business as defined for the Section 199A deduction.

Combine Home Sale with the 1031 Exchange

You don’t often get the opportunity to even consider making a tax-saving double play. But your personal residence combined with a desire for a rental property can provide just such an opportunity.

The tax-saving strategy is to combine the tax-avoidance advantage of the principal residence gain exclusion break with the tax-deferral advantage of a Section 1031 like-kind exchange. With proper planning, you can accomplish this tax-saving double play with full IRS approval.

The double play is available if you can arrange a property exchange that satisfies the requirements for both the principal residence gain exclusion break, and tax deferral under the Section 1031 like-kind exchange rules.

The kicker is that tax-deferred Section 1031 exchange treatment is allowed only when both the relinquished property (what you give up in the exchange) and the replacement property (what you acquire in the exchange) are used for business or investment purposes (think rental here).

Clarifying Example

Let’s say your principal residence—owned for many years by you and your spouse—is worth $3.3 million. You convert it into a rental property, rent it out for two years, and then exchange it for a small apartment building worth $3 million plus $300,000 of cash boot paid to you to equalize the values in the exchange.

Your basis in the former residence is only $400,000 at the time of the exchange. You realize a whopping $2.9 million gain on the exchange: proceeds of $3.3 million (apartment building worth $3 million plus $300,000 in cash) minus basis in the relinquished property of $400,000.

Now, let’s check on your tax bite. You can exclude $500,000 of the $2.9 million gain under the principal residence gain exclusion rules. So far, so good!

Because the relinquished property was investment property at the time of the exchange (due to the two-year rental period before the exchange), you can defer the remaining gain of $2.4 million under the Section 1031 like-kind exchange rules. Nice! No taxes on this deal.

Pay No Income Taxes Ever

If you hang on to the apartment building until you depart this planet, the deferred gain will be eliminated from federal income taxes thanks to the date-of-death basis step-up rule. Under the date-of-death rule, the tax code steps up the basis of the building to its fair market value as of the date of your death.

Example. You die. Your heirs inherit the building at its new stepped-up basis. They sell the building for its date-of-death fair market value. Presto, no income taxes.

Of course, you do need to consider estate taxes if your estate is greater than $11.4 million.

How to Handle Multiple Rental Activities and the 199A Deduction

There’s a lot of confusion out there around your rental activity and Section 199A. Your Section 199A considerations multiply when you have multiple rental activities. Here’s what you need to consider:

  • Are your rental activities multiple trades or businesses, or one trade or business?
  • Can you aggregate the rentals for Section 199A purposes? Do you want to?
  • How does the Section 199A rental safe harbor impact your Section 199A deduction if you use it?

Whether your rental activities are each a trade or business, or they constitute one trade or business, is inherently based on the facts of your particular situation. The IRS also believes that multiple trades or businesses will generally not exist within an entity unless it can use different methods of accounting for each trade or business under the Section 466 regulations. These regulations explain that you can’t consider a trade or business separate and distinct unless you keep a complete and separable set of books and records for that trade or business.

This determination is an important factor for you if any one rental activity (taken individually) doesn’t rise to the level of a trade or business, but all the rental activities (viewed collectively) do rise to the level of a trade or business. One of the factors the IRS looks to when determining whether a rental activity is a trade or business is the number of properties rented.

Aggregation

The Section 199A regulations allow you to aggregate multiple trades or businesses such that you treat the aggregated group as one trade or business for determining your Section 199A deduction. This is an important consideration if one or more of your rental businesses have insufficient wages or unadjusted basis in assets (UBIA) to get the maximum Section 199A deduction for that property.

The final regulations tell us you can aggregate, in most circumstances, provided that the rental activities share centralized administrative functions, such as accounting, legal, and human resources functions. The big wrinkle is the type of rental business: you generally can’t aggregate residential rental businesses and commercial rental businesses with each other because they aren’t the same type of property.

Rental Safe Harbor

Along with the final regulations, the IRS gave you an optional safe harbor to deem your rental activities as qualifying for the Section 199A deduction. The safe harbor isn’t the best strategy because most rentals qualify as a trade or business anyway.

Improvement Property Update

Qualified improvement property is any improvement to the interior portion of a building that is nonresidential real property (think office buildings and shopping centers) if you place the improvement in service after the date you place the building in service.

Lawmakers intended qualified improvement property to be 15-year property and eligible for 100 percent bonus depreciation. Not so.

Due to a drafting error in the Tax Cuts and Jobs Act (TCJA), qualified improvement property is currently 39-year property and ineligible for bonus depreciation.

One possible workaround for some taxpayers: qualified improvement property is Section 179 property, so you can elect to expense it using Section 179. But as you probably know, Section 179 is not available to everyone and has its limitations, which can affect your ability to claim it.

Congress has several bills that contain the fix. For example, the Tax Technical and Clerical Corrections Act, introduced in the House of Representatives, would fix the qualified improvement property issue retroactively, along with many other TCJA issues.

The best solution is to wait. If you can, hold off filing your tax return until after lawmakers fix the problem retroactively. Then you can claim bonus depreciation on your 2018 qualified improvement property on your extended 2018 tax return.

If Congress retroactively fixes the qualified improvement property issue after you file your 2018 tax return, you’ll have to amend your tax return in order to get the benefits of qualified improvement property being 15-year property.

What Can I Do If My K-1 Omits 199A Information?

Tax reform’s Section 199A deduction often confuses small-business owners and tax professionals alike. It’s quite possible you’ll get a Schedule K-1 from a business that omits the information you need to calculate your deduction.

What do you do?

You have a big problem. Without a properly completed Schedule K-1, your Section 199A deduction is a big fat $0.

Best option: fix the K-1. You should request a corrected Schedule K-1 from the entity giving you the Schedule K-1 so you have the information you need to calculate your Section 199A deduction.

Not-so-great options. If you can’t get a corrected Schedule K-1, you have two options:

  1. Take no Section 199A deduction.
  2. File Form 8082 with your tax return and claim the Section 199A deduction.

You file Form 8082 with your tax return when you take a position on your tax return that is inconsistent with the Schedule K-1 you received.

Since the final regulations presume the Section 199A amounts are $0 when omitted, it is possible Form 8082 can rebut that presumption. The truth is, we do not know for sure.

You can determine qualified business income, but not W-2 wages or unadjusted basis immediately after acquisition of qualified property, from the other information on the Schedule K-1. Therefore, the Form 8082 option is likely available only if you are under the Section 199A taxable income threshold ($315,000 on a joint return or $157,500 for all other filing statuses).

You also might use Form 8082 if your Schedule K-1 has wrong Section 199A information—for example, if the K-1 indicates the business is a specified service trade or business, but it is not.

Amended return. If you did not take a Section 199A deduction and you eventually get a corrected Schedule K-1, you can claim the deduction on an amended return and obtain a refund.

Good News: Most Rentals Likely Qualify as Section 199A Businesses

The Tax Cuts and Jobs Act tax reform added new tax code Section 199A, which created a 20 percent tax deduction possibility for you if your rental property (a) has profits and (b) can qualify as a trade or business.

As the law now stands, with rentals that achieve trade or business status, you win. Your business-status rental property creates the following five possible tax benefits for you:

  1. Your rental property can create a Section 199A tax deduction of up to 20 percent of the rental property’s qualified business income.
  2. Your rental property receives tax-favored Section 1231 treatment, which (upon sale) delivers with a tax loss—an ordinary loss (the best kind of loss)—and with a tax-favored capital gain (the best kind of gain).
  3. Your rental property can create the home-office deduction if you meet the other home-office requirements of exclusive and regular use.
  4. Your rental-business status creates rental property deductions for the cost of your attendance at rental property meetings, seminars, and conventions.
  5. Your rental-business status enables Section 179 expensing for certain assets used in the business (special rules apply to the real property).

To obtain the benefits listed above, you must have a rental property that qualifies as a trade or business.